The definition of investment risk is not the probability of losing money, but the probability that the investment outcome will not be what you expect. Risk therefore includes volatility as well as loss. Psychologists have shown that investors put more weight on the pain associated with a loss or drop in value, than they do on the good feelings they get from gains. Whether you use an adviser or manage your own portfolio, it is essential to start with a deep understanding of your risk tolerance.
Risk capacity, which is another essential ingredient, reflects the degree to which, for a given level of risk, your financial situation can withstand the impact of loss. The stronger your financial situation, the higher your risk capacity is likely to be, even if you have a low tolerance of risk. A low capacity for risk combined with a high risk tolerance can be a recipe for disaster if not carefully managed.
Your risk tolerance and risk capacity will underpin the asset allocation for your investment portfolio; that is, the overall weighting given to cash, fixed interest, property and shares. In a well diversified portfolio, the risk (volatility) and return of the portfolio will be determined to a far greater extent by general market movements than specific investment choices. Making choices about how much of your portfolio to allocate to shares is a much more significant decision therefore, than which shares to buy to make up that portfolio. As a general rule, the lower your tolerance and capacity for risk, the more heavily weighted your portfolio should be towards cash and fixed interest investments. The art of designing a good investment portfolio is to first understand your risk tolerance and capacity, to then determine an appropriate asset allocation, and to manage risk through diversification.
